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Cotton: Important Historical Context

Since July 31, cotton prices have wanted to do nothing but go down. One might say that it is simply a function of oil’s decline. This is, no doubt, a driver. But I don’t buy it in full. After having close to zero correlation for most of the year, both have slid meaningfully over the past few weeks. In fact, cotton has been higher beta than oil in recent weeks – a reversal of what we have seen in past cycles when they have correlated.

This is pretty important to me given that a material slide in cotton costs could ease the apparel industry’s supply chain strain for a brief while – which would cause me to evaluate where I stand on some of these names vis/vis horrible ‘trend’ and decent ‘trade’.

Leave it to my colleague Andrew Barber to find something in the commodity history books to explain this away. The analysis by Moore Research Center below shows how the seasonal nature of planting/harvesting cotton rather consistently flows through to the yy change in the price of the commodity.

The seasonally weakest time period over the past 33 years? You guessed it. Mid August. It is always tough for me to stomach that ‘seasonal trading charts’ like this have the right to exist. We’ll see if this continues in the coming weeks.

WRC: Phelps is History

I know it seems like every day I am throwing out another reason why not to like Warnaco. I’m not trying…the facts simply keep rolling in. The latest has to do with none other than Michael Phelps and Nike.

Phelps created a brand for himself faster than any human I have ever seen. Everything from inspiration, hard work, team focus, and sheer determination (not to mention 12k calories per day of carb loading). Product endorsers are chasing him like wildfire. Heck, Mrs. Phelps even took Donovan McNabb’s mother’s job as a soup pitch-mom.

Speedo currently endorses MP for swimwear and goggles. That’s going to change, in my humble opinion.

Let’s assemble a little narrative…

For the first time since I can remember, Nike bowed to avert a PR disaster and allowed its swimmers wear Speedo suits at the games. A wise move. Speedo’s product was superior. If Nike athletes lost, then it would be blamed on product. Not good. If they swam in Speedo and lost, then that’s ammo for Nike to bash the competition.

Either way, I would not want to be part of the swim product/marketing team at Nike leading up to the games. I definitely would not want to be part of the team as Michael Phelps garnered more attention than almost any athlete in modern Olympic history. Nike hates to lose.

What comes next? Phelps almost loses gold in the 200 meter butterfly as his Speedo goggles failed and filled with water.

Phelps goes on to conquer the swimming world, and US hearts alike. This missed product/marketing opportunity on a world stage coincided with Liu Xiang (Chinese hurdler, National hero, and Nike guy) failing to compete in his race. It also synchs with non-Olympic developments, such as Lance Armstrong’s wind-down as a Nike torchbearer, Tiger’s injury, and the seemingly unstoppable Federer being handed some high-profile losses. Granted – Roger lost to another Nike athlete (Rafael Nadal), but the rivalry has not been the brand builder one might have thought. Nike is probably thinking that it needs new blood.

Combine the fact that it wants to crush Speedo with the need for someone who transcends a single sport (i.e. can be on the cover of SI, Time, and Men’s Health all at once) and you’ve got the perfect Nike pitchman.

The math here is pretty simple. Nike has about $2.3 billion (with a B) in SG&A. Warnaco spends about $100mm, with less than 10% going to Speedo. Nike could pay $10mm annually in a heartbeat. For Speedo to match, it would cost 15% of EPS. Nike’s toll would be only 0.3% of EPS. This battle would be the equivalent of the US invading Aruba.

The bottom line here is that my confidence level is quite high that Nike is going to either a) Make Warnaco/Speedo pay-up meaningfully to retail Phelps, or b) lure away WRC’s highest profile endorsee.

LDG, Part IV: Levering Up To Buy An Asset Headed Into A Secularl Slowdown?

Pharmacy revenue growth appears to be in the grip of a secular slowdown that has no end in sight. While the "The Aging Baby Boomers" are a source of comfort to many investors, a closer look at the individual components that drive pharmacy revenues, suggest just the opposite, a slowing demand curve.

New drug approvals, unit inflation, and insurance coverage together point to tougher times for the pharmacy supply chain. Sum of the parts calculations place the low end of pharmacy revenue growth at 1% while putting an upper limit on growth at 3.5%, under the most favorable conditions.

Using the most recent data available from the National Health Expenditures Survey of 2004, which details per capita spending on pharmaceuticals, together with the population forecast from the US Census Bureau, total prescription dollar growth will remain at the moribund rate of 1.5% or lower for the foreseeable future.

New products from the Pharmaceutical Industry have not kept pace according the FDA. Whether this is a tougher, more risk-averse FDA, or bad decisions by R&D executives, the pace of innovation has been declining for over a decade.

Prescription inflation is slowing according to the CPI (bls.gov) While generic introductions affect the shape of the curve, it appears the Pharmaceutical Industry has entered a new phase of lower pricing power. Lower unit inflation for prescriptions directly affects same store comps, but also slows the rate of change in the spread between wholesale acquisition costs and reimbursement for the pharmacy.

According to the Kaiser Family Foundation, a 1% change in the unemployment rate creates 1.1M uninsured individuals and increases Medicaid rolls by 1.0M, by law the lowest priced pharmaceutical buyer. Through 2006, the ranks of the uninsured were already climbing. With 154.6M in the civilian workforce, further increases in unemployment could represent a 50 to 100bps drag on pharmacy alone.

Tom Tobin
Managing Director
Healthcare

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A REVEALING IGT/WMS/BYI “QUADRANT” ANALYSIS

Not sure it’s embezzlement but I’m stealing some intellectual property from my partner Brian McGough. Brian has developed a very useful tool for analyzing apparel companies. In a continuous effort to take a fresh approach, I’ve incorporated his quadrant tool to analyze the gaming equipment sector. The quadrant analysis is just one of many unique tools I plan to roll out.

  • WMS sits comfortably in Quadrant 1: The Sweet Spot. In fact, the company has not wavered from this comfort zone during the last 2 years. Despite selling into a trough domestic replacement environment, sales are growing faster than inventory and gross margins are improving. Essentially, this is a tribute to management. The company grew sales faster than inventory without sacrificing gross margins for 8 straight quarters. WMS is not discounting to keep inventory low and drive sales. This is very healthy, particularly considering the challenging environment.

  • The IGT chart is very different, especially recently. Calendar 2008 has not been kind to IGT’s fundamentals or its stock price. The quadrant analysis is revealing. Trough replacement demand and market share declines have double teamed IGT’s revenue picture. Unfortunately, inventories continue to build. Q2 improved from Q1 in that gross margins actually ticked up a bit. The next few quarters will be very interesting. I’m not sure IGT can do much about the near-term revenue outlook but the story looks better if they can get inventories under control and continue the sequential margin growth. As I’ve written about, IGT is a potential long-term margin story. Headcount reductions and other SG&A cuts are the low hanging fruit and the company is making progress there. Continued gross margin improvement may come from more overseas manufacturing. More to come on these topics.

  • I have not included a BYI chart but suffice it to say that margins continue to expand and sales are outpacing inventory. Aesthetically, the chart line whips around so much it is not useful. The turnaround efforts over the past few years have yielded some drastic improvement in revenue growth and margin expansion. BYI reports tomorrow and we may have more to say on this one.

WMS firmly entrenched in the Sweet Spot
IGT needs to improve its inventory situation and maintain CY Q2 margin expansion

German Inflation +8.9% Year Over Year; Highest Since 1981

Germany's monthly inflation report wasn't as high as that reported here in the US, but it was pretty darn close. Germany's PPI report came in at +8.9% year over year.

This was the highest number they have printed since 1981. Coincidentally, June of the same year is when US inflation (PPI) was last reported as high as today's report suggested.

The top 3 economies in the world (US, Japan, and Germany) are effectively telling you that they are experiencing economic stagflation. This is not good. Lehman , Goldman, and Merrill have plenty more to be worried about other than a credit crisis now.

It is global this time, indeed.

KM

It's not all about commodities - inflation hits +9.8% y/y!

This morning's PPI report for the month of July was 2x higher than the Street's expected number. This caught some of the "deflation" bulls offside. Reported inflation is not a straight line to the rate of change in the CRB Commodities Index. Pharmaceuticals and Autos inflated materially.

The attached chart shows the inflation that continues to mount within the cost structures of US producers. Irrespective of the fact that this report is a lagging economic indicator, be sure that this will be a "Main Street" political football that Obama shows no shame in throwing down field.

Stagflation remains economic reality in the USA, regardless.
KM

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